Friday, October 14, 2011

Inflation and Real Exchange Rates in China

China's exchange rate policy has been in the news quite a bit recently, thanks to the US Senate's action this week to try to punish China for it. Putting aside the legal issues for a moment, it has been noted by various observers (e.g. Matt Yglesias) that the problem of China's undervalued exchange rate is at least partially resolving itself over time. This week's Economist picks up this theme:
And now, protectionism
America’s latest anti-China bill tackles a problem already being solved

...The problems this bill purports to address are already being resolved. The Economist has long argued that a flexible yuan is in the interests of both China and its trading partners. It would hasten the reorientation of China’s economy from exports to consumer spending, give its central bank more freedom to fight inflation, and divert demand to depressed Europe and America, catalysing an essential rebalancing of the global economy.

Belatedly, China recognises this. Since June last year the yuan has appreciated 7% against the dollar. The rise in China’s relative costs has been even greater given its higher inflation rate. With stimulative fiscal and monetary policy bolstering domestic demand, China’s current-account surplus has shrunk by two-thirds, from 10% of GDP in 2007. Meanwhile America’s trade deficit has narrowed, and manufacturing employment has stopped falling. All this means the yuan is far less undervalued than it was a few years ago—if at all.
If you had asked me yesterday how much the yuan (CNY) had appreciated against the dollar since China released the yuan from its long-standing peg of 8.28 CNY/USD back in 2005, I could have told you that the CNY is now about 20% stronger in nominal terms. But then I would have been quick to add that since inflation in China has been considerably higher than in the US, in real terms -- i.e., in terms of actual purchasing power once inflation is accounted for -- the CNY has probably appreciated by more like 30% to 40%.

It turns out I would have been pretty badly wrong. Last night I pulled data from Principal Global Indicators (an excellent multi-country data site, by the way) on actual inflation in China and the US over the past few years, and this is what the consumer price index looks like in each country (try to look past the terrible seasonal fluctuations in the Chinese data):

It turns out that, at least according to official statistics (and yes, we probably need to take them with a large grain of salt), consumer prices in China have risen only by a total of only 6.7% more than prices in the US since 2005. The inflation differential that had loomed large in my mind is not so great after all.

In addition to the possible unreliability of Chinese inflation statistics, there may be a second explanation for the fact that Chinese inflation has been less different from US inflation than I imagined: changes in consumer prices in both countries since 2005 have been largely driven by changing energy prices. So for example, the US CPI is currently up almost 4% over a year ago thanks to higher energy prices (excluding energy prices, US inflation remains very modest) -- and China has experienced a bulge in its own inflation rate at the same time, in part for exactly the same reason. Similarly, the collapse in energy prices in late 2008 and early 2009 caused inflation rates in both countries to plummet at the same time. In short, the role that energy costs play in consumer price inflation in both countries may explain why inflation rates in the US and China have tracked each other surprisingly closely in recent years, as shown below.

The result is that when the consumer price index is used to measure inflation differentials between China and the US (and yes, I know that the CPI is not the ideal inflation measure to use for that, but Chinese inflation data is woefully limited, and as economists we're forced to look where there's light), the Chinese currency's real exchange rate has only appreciated a little bit more than the nominal exchange rate. The final picture below shows both series, setting January 2007 = 100.

So clearly my guess that China's currency has appreciated against the dollar in real terms by 30% to 40% would have been pretty far off. The real answer is that the real appreciation of the yuan is only a few percent more than the nominal appreciation. Put another way, almost all of the movement in China's real exchange rate has been due to movements in the nominal exchange rate.

So if you're looking for China's undervalued yuan to correct itself over time, you can't count on inflation differentials to do much of the work, at least based on the experience of the past few years. Any significant changes in China's real exchange rate are probably going to have to come from further changes in the nominal CNY/USD rate.


  1. According to Michael Pettis the Yuan should be appreciating due to productivity improvements, so in terms of PPP the exchange rate probably hasn't moved at all, perhaps even moving the other way.

  2. Anonymous2:40 AM

    First, there is more light than you think on unit labor costs, enough to be sure the gap is at least twice what it is for the CPI. Second, your time-line is too long. The big divergence of real and nominal rates starts only summer of 2010. More here

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